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Optimal Price Indices for Targeting Inflation Under Incomplete Markets

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  • Rahul Anand
  • Eswar Prasad

Abstract

In models with complete markets, targeting core inflation enables monetary policy to maximize welfare by replicating the flexible price equilibrium. We develop a two-sector two-good new-Keynesian model to study the optimal choice of price index in markets with financial frictions. We find that, in the presence of financial frictions, a welfare-maximizing central bank should adopt flexible headline inflation targeting a target for headline CPI inflation with some weight on the output gap. These results are particularly relevant for emerging markets, where the share of food expenditures in total consumption expenditures is high and a large proportion of consumers are credit constrained.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 10/200.

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Length: 62
Date of creation: 01 Sep 2010
Date of revision:
Handle: RePEc:imf:imfwpa:10/200
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Keywords: Inflation targeting; Consumer price indexes; Economic models; Emerging markets; Food production; Price elasticity; Welfare; inflation; monetary policy; aggregate demand; central bank; monetary economics; monetary policy rule; price inflation; relative price; relative prices; price stability; average inflation; optimal monetary policy; monetary fund; real wages; monetary policy rules; monetary policy regimes; inflation targeting regime; nominal interest rate; coefficient on inflation; monetary phenomenon; monetary policy framework; rate of inflation; monetary authority; inflation dynamics; price level; macroeconomic stability; real variables; rational expectations; inflation objective; real interest rate; inflation rate; macroeconomic analysis; increase in inflation; measure of inflation;

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Find related papers by JEL classification:
  • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
  • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
  • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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Cited by:

  1. Prasad, Eswar, 2013. "Distributional Effects of Macroeconomic Policy Choices in Emerging Market Economies," IZA Discussion Papers 7777, Institute for the Study of Labor (IZA).
  2. Marc Pourroy & Benjamin Carton & Dramane Coulibaly, 2012. "Food Prices and Inflation Targeting in Emerging Economies," Working Papers 2012-33, CEPII research center.
  3. Michael Plante, 2013. "TheLong-RunMacroeconomicImpactsofFuelSubsidies," Caepr Working Papers 2013-002, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  4. Changyong Rhee & Hangyong Lee, 2013. "Commodity price movements and monetary policy in Asia," BIS Papers chapters, in: Bank for International Settlements (ed.), Globalisation and inflation dynamics in Asia and the Pacific, volume 70, pages 71-77 Bank for International Settlements.
  5. José de Gregorio, 2012. "Commodity Prices, Monetary Policy and Inflation," Working Papers wp359, University of Chile, Department of Economics.
  6. Michael Plante, 2013. "The Long-Run Macroeconomic Impacts of Fuel Subsidies," Caepr Working Papers 2013-002, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  7. Plante, Michael, 2014. "The long-run macroeconomic impacts of fuel subsidies," Journal of Development Economics, Elsevier, vol. 107(C), pages 129-143.
  8. Andrew Filardo & Marco Jacopo Lombardi, 2014. "Has Asian emerging market monetary policy been too procyclical when responding to swings in commodity prices?," BIS Papers chapters, in: Bank for International Settlements (ed.), Globalisation, inflation and monetary policy in Asia and the Pacific, volume 77, pages 129-153 Bank for International Settlements.
  9. Paolo Pesenti, 2013. "Theoretical notes on commodity prices and monetary policy," BIS Papers chapters, in: Bank for International Settlements (ed.), Globalisation and inflation dynamics in Asia and the Pacific, volume 70, pages 79-90 Bank for International Settlements.

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